Tag Archives: IRAs

IRA Basis Isolation Revisited

Basis in IRAs is a funny thing. It necessitates the Pro-Rata Rule, one of the least understood tax rules affecting financial planning. IRA basis creates all sorts of confusion, making traditional IRAs less user friendly. 

Further, the value of basis in a traditional IRA is whittled away by inflation. Basis is generally the undistributed prior after-tax (or nondeductible) contributions in the IRA. Since basis might be distributed or converted years, perhaps decades, after the contribution, and is not increased for inflation, its value diminishes the longer it exists. 

Thus, basis isolation techniques gain attention. The idea is to use the basis in an advantageous way to (1) harvest it prior to its value being eroded away by inflation and (2) move basis amounts into Roth IRAs relatively tax free. 

Basis Isolation Techniques

The most basic basis isolation technique is a properly done Backdoor Roth IRA. IRA basis is created and quickly used to move money into Roth IRAs. The basis is fully used before inflation can erode its value.

The Backdoor Roth IRA is a simple tactic that, employed over many years, can be tremendously beneficial. It has very little downside risk and is relatively simple to implement. 

Another basis isolation tactic is the qualified charitable distribution (“QCD”). This one is even easier than the Backdoor Roth IRA. QCDs do not take IRA basis when transferred to a charity. Thus, distributions the taxpayer receives and/or Roth conversions attract more of the available IRA basis to reduce the taxable amount. A small IRA basis benefit, but still helpful. 

What about situations where someone has (1) significant basis in an IRA and (2) significant pretax amounts in an IRA? Now we have complexity, risk, and opportunity. The tactic I wrote about which could be useful in this situation is the Basis Isolation Backdoor Roth IRA.

The Basis Isolation Backdoor Roth IRA does the following:

  1. Cleans up IRA basis and uses it before inflation reduces its value. 
  2. Creates a Roth IRA the owner can use for tax free withdrawals in retirement. 
  3. Reduces future required minimum distributions (“RMDs”) by reducing the size of a traditional IRA. 

I believe advisors and IRA owners need to proceed with caution when it comes to the Basis Isolation Backdoor Roth IRA. What initially looks incredibly attractive may turn out to be an unattractive planning technique.

Note that some 401(k) and other qualified plans do not accept roll-ins of IRAs. Some other plans only accept roll-ins of a certain type of IRA, a “conduit IRA.” A conduit IRA is an IRA comprised only of old 401(k)s, 403(b)s, governmental 457s, and other qualified plans and the growth thereon. Thus, plans requiring that the rolled-in IRA be a conduit IRA cannot be used to facilitate isolation of IRA basis created by old nondeductible traditional IRA annual contributions, since the growth on nondeductible traditional IRA contributions is not eligible to be moved over to such plans. 

Basis Isolation Backdoor Roth IRA Examples

To analyze whether employing a sophisticated IRA basis isolation technique is advisable, I’m going to present two examples. These examples will illustrate when I favor and when I disfavor using the Basis Isolation Backdoor Roth IRA. 

Example 1: Basis Isolation Backdoor Roth IRA into a Large Employer 401(k)

April, age 48 in 2026, works for Apple Inc. She is a participant in their 401(k) plan. In 2022 through 2026 her adjusted gross income was such that she qualified for neither a deductible annual contribution to a traditional IRA nor an annual contribution to a Roth IRA. In 2022 she contributed $6,000 to a traditional IRA. In 2023 she contributed $6,500 to a traditional IRA. In 2024 she contributed $7,000 to a traditional IRA.

All of these contributions were nondeductible. In 2025 April learned about the Backdoor Roth IRA and the Pro-Rata Rule. Thus, she did not make any contributions to a traditional IRA for 2025. 

April is planning on retiring in five years. She has a sizable balance in her 401(k). Her taxable brokerage account is worth $100,000, and her traditional IRA is worth $100,000, consisting of (1) the three nondeductible contributions ($19,500 total), (2) a $20,000 401(k) rollover from a former employer plan and (3) investment growth on both 1 and 2. April has no Roth IRAs or health savings accounts.

Only for sake of this analysis, assume Apple’s 401(k) both accepts all IRA roll-ins (other than IRA basis) and offers satisfactory low-cost investment options. 

April proceeds as follows:

Step 1: In May 2026, April contacts her IRA custodian and splits her $100,000 traditional IRA into two IRAs. The first is $19,700 invested in a money market account (her basis amount of $19,500 plus a small $200 round up). This IRA is the Leave Behind IRA. The second IRA (IRA 2) is worth $80,300 and can be invested in whatever April desires.

Step 2: April works with the Apple 401(k) plan and her IRA custodian to arrange a direct trustee-to-trustee transfer of IRA 2 from the traditional IRA to April’s Apple 401(k) account. 

Step 3: After the completion of Step 2, April converts the entire Leave Behind IRA (now worth $19,900 due to interest accruing on the money market fund) to a Roth IRA. Due to IRA basis isolation, only $400 of the $19,900 is taxable to April on her 2026 federal income tax return. 

Steps 1 through 3 are the Basis Isolation Backdoor Roth IRA. 

Step 4: April executes the two steps of a 2026 Backdoor Roth IRA, getting another $7,500 (plus a small amount of interest) into her Roth IRA.

Step 5: April ensures that as of December 31, 2026, she has $0 balances in all traditional IRAs, traditional SEP IRAs, and traditional SIMPLE IRAs. 

I’m drafting this at the end of the Winter Olympics. Recall that many of the figure skaters make the “heart sign” gesture after their skates. You can feel free to picture me making the heart sign gesture when thinking about April’s Basis Isolation Backdoor Roth IRA. 

Why do I like this basis isolation play for April? Let me list the reasons.

Reason One: Helpful to April in early retirement. Recall that April intends to retire at age 53. Recall further that April has just $100,000 in a taxable brokerage account and no Roth IRA or HSA. Steps 1 through 4 create approximately $27,500 in Roth IRA basis that April can access in early retirement prior to age 59 ½ without tax or penalty. Further, the Basis Isolation Backdoor Roth IRA opens up the Backdoor Roth IRA for the last five years of her career, allowing her to create even more Roth IRA basis that can help fund early retirement advantageously from a Premium Tax Credit perspective and an income tax perspective.

Reason Two: Relatively modest IRA transfer. April moves approximately $80,000 of pretax IRA money. Any movement of pretax IRA money involves, however small, an element of risk. While $80,000 is not a tiny sum, it is also not a huge sum. It’s not the lion’s share of April’s wealth. Execution risk is mitigated in April’s case by the modesty of the sum moving into the Apple 401(k).

Reason Three: Using a large employer 401(k). Unless you work at Apple, you, like me, have little insight as to the contours and compliance record of Apple’s 401(k). Regardless, we would be absolutely shocked if we woke up tomorrow morning and read that the IRS and/or the Department of Labor challenged Apple’s 401(k) plan qualification. 

Why? Disqualifying Apple’s 401(k) plan would create problems for thousands of voters. Congressmen from multiple Congressional districts, and perhaps even Senators, would strongly question the IRS and/or the Department of Labor about the issue. We know the motivations of the IRS and Department of Labor in this regard. They have every incentive to avoid significant headaches and work with Apple to get to a place where Apple’s 401(k) qualifies as a 401(k). 

None of this is to cast aspersions at IRS and/or Department of Labor personnel. It’s simply acknowledging reality. How often do you look to stir up a hornet’s nest at your place of work? 

As discussed above, I have absolutely no knowledge or opinion about the qualification of Apple’s 401(k) and/or the quality of the investments in it. I simply raise possibilities and discuss pivotal actors’ motivations to explore planning where one uses a workplace 401(k) to facilitate an IRA basis isolation transaction. 

Helping fund early retirement. Relatively low risk of transferring pretax amounts. Parking assets in a stable, established, large employer 401(k) to achieve the objective.

April’s Basis Isolation Backdoor Roth IRA is quite attractive, in my opinion. 

Example 2: Basis Isolation Backdoor Roth IRA into a Solo 401(k)

Jack, age 66 in 2026, and his wife, Becky, also age 66 in 2026, retired two years ago. Jack made $80,000 of nondeductible traditional IRA contributions over the years. With rollovers of prior large employer 401(k)s, today Jack’s traditional IRA is worth $2 million. Jack is very happy with the financial institution holding the traditional IRA and the investments offered by that institution. 

Jack and Becky currently live off taxable brokerage accounts, currently worth $1 million. Becky also has $500,000 in a traditional IRA with no basis. Neither Jack nor Becky has a Roth IRA or an HSA. 

Jack is interested in isolating his $80,000 traditional IRA basis and getting it into a Roth IRA. He’s heard about the Solo 401(k) and is intrigued. He concocts an idea. He will drive for Lyft part time for three months. Doing so brings in $3,000 of revenue. After expenses and a deduction for half of his self-employment taxes, he has $2,000 of net profit.

Jack proceeds as follows:

Step 1: Jack takes the position that he has self-employment income in 2026 and thus opens a Solo 401(k). He makes a maximum $2,000 employee deferral contribution for 2026.

Step 2: In August 2026, Jack contacts his IRA custodian and splits his $2 million traditional IRA into two IRAs. The first is $80,200 invested in a money market account (his basis amount of $80,000 plus a small $200 round up). This IRA is the Leave Behind IRA. The second IRA (IRA 2) is worth $1,920,000 and can be invested in whatever Jack desires.

Step 3: Jack works with the Solo 401(k) plan custodian and his IRA custodian to arrange a direct trustee-to-trustee transfer of IRA 2 from the traditional IRA to Jack’s Solo 401(k) account. 

Step 4: After the completion of Step 3, Jack converts the entire Leave Behind IRA (now worth $80,500 due to interest accruing on the money market fund) to a Roth IRA. Due to IRA basis isolation, Jack takes the position that only $500 of the $80,500 is taxable to him on his 2026 federal income tax return. 

Steps 2 through 4 are the Basis Isolation Backdoor Roth IRA. 

Step 5: Jack ensures that as of December 31, 2026, he has $0 balances in all traditional IRAs, traditional SEP IRAs, and traditional SIMPLE IRAs. 

Jack’s Basis Isolation Backdoor Roth IRA makes me feel the way my New York Jets fandom has in recent years. For those unaware, the Jets currently have the longest streak of missing the playoffs in North American major sports. 

Why do I disfavor this basis isolation play for Jack? Let me list the reasons.

Reason One: No help solving retirement funding issues. Jack and Becky’s retirement is well funded. Unlike April, they do not need to control income for Premium Tax Credit purposes. Jack and Becky are currently living off taxable accounts. As I have previously discussed, they may pay practically no federal income tax doing so. 

Why are Jack and Becky moving a large account and doing sophisticated distribution planning when they already have years of paying hardly any federal income tax?

Reason Two: Large IRA transfer. Jack moves approximately $1.92M of pretax IRA money. Any movement of pretax IRA money involves, however small, an element of risk. $1.92 million is the lion’s share of Jack and Becky’s financial wealth. Execution risk on a $1.92 million transfer of assets already in a satisfactory location, a traditional IRA with a liked institution, is not something I favor successful retirees affirmatively planning into. 

Reason Three: Using a Solo 401(k). Compare the IRS disqualifying Jack’s Solo 401(k) with disqualifying Apple’s Solo 401(k). No Congressman is reaching out to the IRS if they disqualify Jack’s Solo 401(k). Further, the success of Jack’s strategy depends on him successfully maintaining his Solo 401(k) in the future. Rocket science? No. But guaranteed? Also, no. 

Is Jack’s Solo 401(k) Valid? 

Contributions of Self-Employment Income

I strongly question whether Jack would have a valid Solo 401(k) in this fact pattern. Consider the Congressional intent behind Solo 401(k)s. Solo 401(k)s allow the self-employed to make significant contributions of self-employment income to retirement accounts. Solo 401(k)s solve for the problem of the self-employed not having access to large employer 401(k) plans. 

Jack’s use of a Solo 401(k) is hardly reflective of the intent behind the Solo 401(k). Jack accumulated years of retirement account contributions in a traditional IRA. He had no need for the Solo 401(k) to accumulate and maintain retirement savings. Further, about a tenth of a percent of the Solo 401(k) balance is funded by “self-employment income.” About 99.9 percent of the balance of Jack’s Solo 401(k) has nothing to do with self-employment. 

These numbers indicate that Jack’s Solo 401(k) has little to do with contributions of self-employment income to save for retirement. 

Is Jack Self-Employed?

As I discussed on page 24 of this article, one needs self-employment to have a Solo 401(k). I strongly question whether Jack’s Lyft driving qualifies as self-employment allowing him to open a Solo 401(k). 

Consider making the case to respect Jack’s Lyft activities as “self-employment.” How is a retired person self-employed? What do Jack and Becky live off of? Accumulated retirement assets or Lyft income? That Jack and Becky live off their retirement savings and not off Jack’s Lyft income is instructive in determining whether that income comes from an activity sufficient to be considered a business to allow Jack to have a Solo 401(k). 

IRA Basis Isolation and Solo 401(k) Stuffing

I’m not shy when I see the IRS in a weak position. In this article, I strongly argue the IRS has a very weak position if they attempt to enforce the literal terms of Notice 2022-6 governing 72(t) payment plans. 

I’m also not shy in acknowledging situations where the IRS may have a strong position. When it comes to stuffing Solo 401(k)s for distribution motivated reasons, I believe the IRS has a strong position. I previously wrote about this when it comes to stuffing a Solo 401(k) for Rule of 55 planning. See pages 24 through 26 of this article. 

I believe the IRS would have a high likelihood of success were they to challenge the validity of Jack’s Solo 401(k). Can you imagine taxing a $2 million traditional IRA through an attempted rollover into an invalid Solo 401(k) just to get $80,000 into a Roth IRA?

After considering Solo 401(k) stuffing in the contexts of both the Rule of 55 and the Basis Isolation Backdoor Roth IRA, I’ve come up with Mullaney’s Solo 401(k) Distribution Planning Principle: 

Do not use a Solo 401(k) for distribution planning. 

Solo 401(k)s can be distributed out of (as I argue in this article), but I disfavor using them to facilitate sophisticated distribution planning such as a Basis Isolation Backdoor Roth IRA. 

Fortunately, Solo 401(k)s remain a great option for accumulation planning for the fully self-employed. 

Tax Planning and New Businesses

I disfavor tax planning that necessitates the starting of a business to achieve retirement tax benefits. 

Picture a financial planner, Jill, recommending to Jane, a self-employed lawyer, that she opens a Solo 401(k). Jill’s recommendation does not necessitate Jane starting a business. Jill simply is recommending a potentially advantageous tactic that Jane’s preexisting business opens the door to. 

Contrast Jane’s preexisting business with Jack’s new “business” of Lyft driving. There are legitimate Lyft businesses operated by thousands of Americans. But in Jack’s case, his Lyft activity does not strike me as likely to be considered a trade or business sufficient to open a Solo 401(k). 

Even if the Lyft activity is a sufficient trade or business, why do tax planning that requires changes in lived experience when the retiree is already financially successful? 

Basis Isolation Backdoor Roth IRA Planning

Factors I view as favorable indicators that the Basis Isolation Backdoor Roth IRA may be a good planning tactic:

  • Need for Roth basis in early retirement
  • Relatively modest pretax amounts in traditional IRAs
  • Possibility of opening up several years worth of Backdoor Roth IRAs
  • Rolling pretax amounts into a large employer 401(k) with good investment selections

Factors I view as indicative that the Basis Isolation Backdoor Roth IRA should be disfavored:

  • No compelling need for Roth basis in early retirement
  • Significant pretax amounts in traditional IRAs
  • No ability to do future Backdoor Roth IRAs
  • Rolling pretax amounts into a Solo 401(k)
  • The necessity to start a business to achieve a tax benefit in retirement
  • Confusion surrounding the actual amount of IRA basis, since IRA basis cannot be rolled into a 401(k) or other workplace retirement plan

The above are my opinions. None of this should be read as advice for you or anyone else. Further, none of this should be read as to say any previously implemented planning in this regard is “wrong.” Rather, all this is intended to provide is my views as to what is desirable and what is not desirable from a planning perspective. 

FI Tax Guy can be your financial planner! Find out more by visiting mullaneyfinancial.com

Follow me on LinkedIn: @SeanWMullaney

This post is for entertainment and educational purposes only. It does not constitute accounting, financial, investment, legal, or tax advice. Please consult with your advisor(s) regarding your personal accounting, financial, investment, legal, and tax matters. Please also refer to the Disclaimer & Warning section found here.

What are the Risks of a 72(t) Payment Plan?

Booming stock markets. Job dissatisfaction. The explosion of 401(k)s since the 1980s. The itch to travel. The desire not to worry about Monday morning. 

We may be on the threshold of an early retirement boom. Many potential early retirees will find the lion’s share of their financial assets are in a traditional 401(k) or traditional 401(k)s. The concern becomes the 10 percent early withdrawal penalty. 

How can I access my retirement accounts prior to age 59 ½ without paying the 10 percent penalty?

Enter the 72(t) payment plan, sometimes called a series of substantially equal periodic payments or “SEPP.” In today’s environment, they are a very viable option for those looking to retire early primarily on traditional retirement accounts. 

There is a drawback: impermissible modifications of a 72(t) payment plan trigger the previously avoided 10 percent penalty and related interest charges. This risks potentially paying the IRS thousands of dollars for a misstep.

What are the risks of a 72(t) payment plan?

I explore the risks of a 72(t) payment plan in this 38 page article titled What are the Risks of a 72(t) Payment Plan? I’m self-publishing it as an article since it is much more comprehensive than a blog post. 

Of course, the article is not legal or tax advice for you or any other individual. 

For those of you who read Tax Planning To and Through Early Retirement, which I recently published with Cody Garrett, CFP(R), please know the article is written differently. The book is very focused on planning covering a plethora of retirement tax planning topics, including planning for 72(t) payment plans. The article is much more akin to a “501” level discussion of the risks of a 72(t) payment plan and the ambiguities in the tax law surrounding 72(t) payment plans. 

If you like this style of writing, I have another self-published article you may enjoy: Solo 401(k)s and the Rule of 55: Does the Answer in 1962?

Enjoy the article and please let me know what you think in the comments below. 

FI Tax Guy can be your financial planner! Find out more by visiting mullaneyfinancial.com

Follow me on LinkedIn: @SeanWMullaney

This post and the linked-to article are for entertainment and educational purposes only. They do not constitute accounting, financial, investment, legal, or tax advice. Please consult with your advisor(s) regarding your personal accounting, financial, investment, legal, and tax matters. Please also refer to the Disclaimer & Warning section found here.

Retire on 72(t) Payments

Want to retire before age 59 ½? Have most of your wealth in traditional tax-deferred retirement accounts? Worried about the 10 percent early withdrawal penalty? 

This post is for you!

Picture it: You’re age 53, have $50,000 in a savings account, a paid-off home, and $2.5M in a 401(k). Including income taxes, you spend about $80,000 a year. You want to retire, but you’re worried about paying the early withdrawal penalty, which would be about $8,000 a year (not factoring in the penalty on the penalty!). 

What to do, what to do? The tax law allows someone in this situation to take a “series of substantially equal periodic payments” to avoid the 10 percent penalty. The payments must occur annually for the longer of 5 years or until the taxpayer turns 59 ½. 

72(t) payments can make retirement possible prior to age 59 ½ when one has most of their assets in traditional deferred retirement accounts. Done properly, these payments avoid the 10 percent early withdrawal penalty. 

Below I explore some of the rules of 72(t) payments (sometimes referred to as a “72(t) payment plan,” “72(t) SEPP,” or “SEPP”) and lay out what I hope will be an informative case study. 

** As always, none of this is personalized advice for you, but rather educational information for your consideration. Consult with your own advisors regarding your own situation. 

72(t) Substantially Equal Periodic Payments

Methods

The IRS and Treasury provide three methods for computing a 72(t) payment. As a practical matter, the third one I discuss, the fixed amortization method, tends to be the most commonly used and most user friendly in my opinion.

The required minimum distribution method allows taxpayers to take a 72(t) payment just like an RMD. Take the prior year end-of-year balance and divide it by the factor off the IRS table. The biggest problems with this method are it tends to produce a smaller payment the younger you are and the payment changes every year and can decrease if the IRA portfolio declines in value. The fixed annuitization method is complex and generally yields a payment less than that of the fixed amortization method from the same sized retirement account. 

The rest of the post focuses on the fixed amortization method of computing 72(t) payments (other than a brief foray into the RMD method to account for changing circumstances)). 

Resource: The MyFRS 72(t) calculator can be helpful to early retirees and those planning an early retirement. While I have not validated the calculator’s coding, I have never seen it produce results that I know to be incorrect. 

Computing Fixed Amortization 72(t) Payments

To compute a 72(t) payment and the size of the 72(t) IRA using the fixed amortization method, we will need to run through some math. Four numbers are required: the interest rate, the life expectancy, the annual payment, and the size of the 72(t) IRA. 

Usually the IRS gives us the interest rate and the life expectancy and we need to solve for the 72(t) IRA size. 

Interest Rate: Notice 2022-6 allows taxpayers to always use an interest rate anywhere from just above 0% to 5%, or, if greater, up to 120% of mid-term federal rate for either of the two months preceding the first 72(t) payment distribution. The IRS publishes that rate on a monthly basis.  

As a general rule, taxpayers will usually want to use the greatest interest rate permitted to as to decrease the size of the 72(t) IRA. Decreasing the size of the 72(t) IRA will usually be advantageous, for the reasons discussed below. 

Life Expectancy: The life expectancy comes to us from an IRS table. While we have three possible choices to use, generally speaking taxpayers will want to use the Single Life Table found at Treas. Reg. Section 1.401(a)(9)-9(b). See Choate, referenced below, at page 587. The taxpayer takes their age on their birthday of the year of the first 72(t) payment and uses the factor from the Single Life Table as the life expectancy. 

Payment: Finally, we, not the IRS, get to determine a number! The payment is simply the annual payment we want to receive as a 72(t) payment every year. While this amount is rather inflexible, as discussed below it will be possible to establish additional 72(t) IRAs and payments to increase the amount received if desired. 

Size of the 72(t) IRA: This is what we’re solving for in order to establish a “right-sized” IRA to produce the desired 72(t) payment. In Google Sheets, we do a present value calculation to solve for the size of the 72(t) IRA that generates the desired payment amount. The formula is rather simple: =-PV(Interest Rate Cell, Life Expectancy Cell, Annual Payment Cell). I put a negative sign in front of the PV to have the size of the 72(t) IRA appear as a positive number. It’s important that the formula be entered in that order and that the formatting be correct in each cell. Further, it is important the interest rate cell has a percentage sign in it. 

Validating a Google Sheets 72(t) IRA Calculation: One technique I recommend to validate a 72(t) IRA calculation in Google Sheets is to use the same formula in Google Sheets on the numbers provided by the IRS FAQ 7. I did that on YouTube here. Note that as applied to the IRS numbers, the final 72(t) size is $6.97 off – an immaterial difference caused by the IRS not using cents. 

Another technique to consider is, after doing one’s own calculations to redo the same calculations using the MyFlorida Retirement 72(t) Calculator. 

Note on 72(t) Payments with non-IRA Accounts: Setting up a 72(t) from a non-IRA is possible but not frequent in practice. It is not possible to divide up a 401(k) account in a manner conducive to establishing a “right-sized” 72(t) payment account. See Choate, referenced below, at page 595. 

Annual Equal 72(t) Fixed Amortization Payments

The computed payments must be made annually and equally. This means that no more and no less than the computed payment comes out every year. I believe that taking an annual flat payment on or around the first payment anniversary date is a best practice. However, this best practice is not required. See also Choate, referenced below, at page 600. For example, monthly payments of the computed amount are allowable. See Choate, referenced below, at page 600. 

Annual payments must be made for the longer of five years or until the taxpayer reaches age 59 ½. 

72(t) Payments Case Study

Let’s return to the example discussed above: it is early January 2026 and you (let’s call you Pat) are 53 years old (your birthday was January 5th) and you want to retire, spending $80K a year from your $2.5M 401(k). Let’s solve for the size of the 72(t) IRA:

Interest Rate: 5.00% (the highest 120% of federal mid-term rate of the previous two months per the IRS is less than 5.00%)

Life Expectancy: 33.4

Payment: $80,000

The size of the 72(t) IRA is $1,286,384.59. See IRS FAQ Q&A 7.

Pat would first transfer (preferably through a direct trustee-to-trustee transfer) the 401(k) to a traditional IRA worth $2.5M. Once in the traditional IRA, Pat would call their financial institution and ask them to divide the traditional IRA into two IRAs: one with exactly $1,286,384.59 (the “72(t) IRA”) and one with the reminder of the traditional IRA (the “non-72(t) IRA”). I recommend initially investing the 72(t) IRA in a money market fund so that it can be clearly established that the beginning account balance was exactly the $1,286,384.59 computed to yield the correct payment. Pat takes the first payment of $80,000 on January 29th from the 72(t) IRA in this hypothetical scenario.

Let’s keep going. Assume that in 2030, when Pat turns age 57 and interest rates are well below 5%, Pat wants to increase their annual withdrawal from $80K to $90K. As discussed below, Pat can’t simply increase the withdrawal from the 72(t) IRA. But since Pat kept a non-72(t) IRA, Pat can slice that one up to create a second 72(t) IRA. That second 72(t) IRA can give Pat the extra $10,000 Pat wants to spend.

Here’s what that looks like.  

Interest Rate: 5.00% 

Life Expectancy: 30.6

Payment: $10,000

The size of the second 72(t) IRA is $153,270.74.

Pat would call their financial institution and ask them to divide the non-72(t) IRA into two IRAs: one with exactly $153,270.74 (the “Second 72(t) IRA”) and one with the remainder of the traditional IRA (the surviving non-72(t) IRA). Pat takes the additional payment of $10,000 also on January 28th from the Second 72(t) in this hypothetical scenario.

Here is what Pat’s withdrawals would look like:

YearBirthday AgeRequired First 72(t) January 29 WithdrawalRequired Second 72(t) January 28 WithdrawalTotal Annual Withdrawal
202653$80,000$0$80,000
202754$80,000$0$80,000
202855$80,000$0$80,000
202956$80,000$0$80,000
203057$80,000$10,000$90,000
203158$80,000$10,000$90,000
203259$80,000$10,000$90,000
203360$0$10,000$10,000
203461$0$10,000$10,000

Remember that the First 72(t) IRA and the Second 72(t) are locked up for a period of time. See Locking the Cage below. The First 72(t) IRA is locked up until and through July 4, 2032, the day before Pat’s 59 ½ birthday. The Second 72(t) IRA is locked up until and through January 27, 2035, the day before the fifth anniversary of the first $10,000 payment from the Second 72(t) IRA. See IRS FAQ 13 on this point. Generally speaking, no amount other than the annual payment should go into, or out of, a 72(t) IRA until the end of the lock-up period.

Maintain Flexibility

I strongly recommend maintaining as much flexibility as possible. One way to do that is to have the 72(t) IRA be as small as possible, leaving as much as possible in a non-72(t) IRA or IRAs. Why? 

First, the non-72(t) can be, in a flexible manner, sliced and diced to create a second 72(t) IRA if wanted or needed. Second, for a variety of reasons Roth conversions are generally to be avoided out of a 72(t) IRA. While those on a 72(t) payment plan often have little need to do Roth conversions, if they are so inclined they are better done out of a non-72(t) IRA.  

Second, it is important to maintain future payment flexibility. Imagine if Pat did not divide the $2.5M traditional IRA into two IRAs. Pat could have simply used a smaller interest rate on the entire $2.5M traditional IRA to get the $80,000 annual payment out. However, then Pat would not have had the flexibility to create a second 72(t) payment stream. This is an important reason that it is usually best to use the highest possible interest rate to lower the 72(t) IRA size and maintain the most flexibility.

72(t) Payment Plan Disqualification

A “modification” to the 72(t) payment plan blows up the plan with unfavorable consequences. In the year of the modification the taxpayer owes the 10 percent early withdrawal penalty plus interest on the penalty on all the previously taken 72(t) payments. See Choate, referenced below, at page 596. 

A blow up after age 59 ½, for those on the five year rule, is bad but tends to be less deleterious than a blow up occurring with respect to a SEPP ending at age 59 1/2. The early withdrawal penalty and related interest are not assessed on 72(t) payments taken after one’s 59 ½ birthday. See Choate, referenced below, at page 596. 

There are a few modifications to a 72(t) payment plan that do not blow it up (i.e., they are permissible and don’t trigger the penalty and interest). See Choate, referenced below, at pages 597-601. Those looking to change the payment amount are often well advised to set up a second 72(t) payment plan (as Pat did) rather than seeking a modification to the existing 72(t) payment plan. 

72(t) Payment Reduction

Imagine that instead of wanting an additional 72(t) payment amount, Pat wanted to reduce the 72(t) payment. This is not uncommon. Perhaps Pat has a significant inheritance in 2030 and thus no longer needs to take an $80,000 annual payment and pay tax on it.

Unfortunately, Pat is not allowed to simply discontinue or reduce the 72(t) payment without triggering the early withdrawal penalty (and interest charges) on the previously taken 72(t) payments.

But, the rules allow a one-time switch to the RMD method. Making the switch is likely to significantly reduce the annual 72(t) payment. For example, if Pat wants a smaller payment starting in 2030, Pat could take the 72(t) IRA balance on December 31, 2029 (imagine it is exactly $1M) and divide it by the age 57 factor off the Single Life Table (29.8) and get a 2030 72(t) payment of $33,557.05. Alternatively, Pat could use the age 57 factor off the Notice 2022-6 Uniform Life Table (41.6) and get a 2030 72(t) payment of $24,038.46.

If Pat makes this one-time switch, Pat will annually compute the 72(t) payment for the remainder of the 72(t) term using the table used in 2030 (see Notice 2022-6 page 6) and the prior-year end-of-year 72(t) IRA balance.

The one-time switch to the RMD method is helpful if the taxpayer wants to significantly reduce their 72(t) annual payment, perhaps because of an inheritance, marriage, YouTube channel blowing up, or returning to work. The availability of this method to reduce required 72(t) payments (if desired) is another reason to keep 72(t) IRAs as small as possible.

72(t) Locking The Cage

The 72(t) IRA should be thought of as a locked cage. No one goes in, and only the 72(t) payment comes out annually. The rigidity with which the IRS treats the 72(t) IRA gives early retirees incentive to use as high an interest rate as possible to get the highest annual payment out of the smallest 72(t) IRA possible.

Just how rigid is the IRS? In one case, the IRS disqualified a 72(t) SEPP because a taxpayer transferred a workplace retirement plan into the 72(t) IRA during the 72(t) payment period. See page 4 of this newsletter (page 4 is behind a paywall). Right, wrong, or other, Notice 2022-6 Section 3.02(e) has not been updated for SECURE 2.0’s adding Section 72(t)(4)(C), which clearly allows for some roll outs from 72(t) IRAs. Thus, this is an area where early retirees should proceed with caution. 

Assuming one is using the fixed amortization method for their 72(t) payments, not a dollar more than the 72(t) SEPP should come out each year. It appears the IRS expects the amount to be equal each tax year, see page 5 of this PLR. 

Further, the 72(t) lockup does not end with the taking of the last payment. Rather, as described in IRS FAQ 13, it ends at the end of the lock up period. So if Sean, age 57 in 2023, takes his first 72(t) SEPP of $10,000 from IRA 1 on July 15, 2023, his taking of payment number 5 ($10,000) on July 15, 2027 does not end the lock up. Sean can’t take any additional money out of IRA 1 until July 1, 2028 (the fifth anniversary of his first $10,000 72(t) payment). 

Practice Point: As of this writing, it is not a good idea to add money to a 72(t) IRA during the lockup period due to Notice 2022-6 Section 3.02(e). This includes never making an annual contribution to a 72(t) IRA and never rolling an IRA, 401(k), or other qualified plan into a 72(t) IRA. Incredibly enough, current IRS guidance prohibits breaking into jail in this regard. 

IRS FAQ 13 is instructive in terms of when the lock up ends. The IRS is clear that the lock up ends on the date of the 59 ½ birthday, not on January 1st of that year. Say Rob, born January 14, 1971, takes his first SEPP of $40,000 on August 16, 2023. His 72(t) IRA is free on his 59 ½ birthday, which is July 14, 2030. Presumably, Rob takes his last $40,000 SEPP on or around August 16, 2029. Nevertheless, he can’t add to or withdraw from his 72(t) IRA prior to July 14, 2030 without blowing up his 72(t) payment plan and incurring significant penalties and interest under the approach of IRS FAQ 13. 

As discussed above, the one-time switch to the RMD method is a permissible modification to the 72(t) payment terms that does not trigger the early withdrawal penalty and related interest on previously taken 72(t) payments.

A Note on the 72(t) Risk Profile

The earlier in life the 72(t) payment plan starts, the greater the risk profile on the 72(t) payment plan. The opposite is also true: the later in life a 72(t) payment plan starts, the lower the risk profile.

Why?

Because the sooner the 72(t) payment plan starts, the more years (and more interest) that can be blown up by a future modification requiring the payment of the 10 percent early withdrawal penalty and interest. 

Consider Pat’s example. If Pat blows up the First 72(t) payment plan in early 2031, Pat owes the 10% early withdrawal penalty and interest on five previously taken 72(t) payments from the First 72(t) IRA (2026 through 2030). If Pat blows up the Second 72(t) payment plan in early 2035, Pat only owes the early withdrawal penalty and interest on the three 72(t) payments received before Pat turned age 59 ½. 

In February 2026 I self-published a 38-page article on the risks presented by 72(t) payment plans. You can access the article here.

72(t) Payment Tax Return Reporting

Taxpayers should keep the computations they and/or their advisors have done to document the 72(t) payment plan. Distributions should be reported as taxable income and on Form 5329. Code 02 should be entered on Line 2 of Form 5329. 

72(t) Is An Exception to More Than One Rule

72(t) payment plans are an exception to the 10 percent early withdrawal penalty. They are also an exception to the general rule that the IRS views all of your IRAs as a single IRA. The 72(t) IRA is the 72(t) IRA. If you have a separate IRA and take ten dollars out of it prior to age 59 ½, you trigger ordinary income tax and a $1 penalty. If you take an additional ten dollars out of the 72(t) IRA prior to the end of the 72(t) lock up, you blow up the 72(t) payment plan and owe the 10 percent early withdrawal penalty and interest on all the pre-59 ½ 72(t) payments. 

Other Penalty Free Sources of Early Retirement Funding

Let’s remember that 72(t) payments are a tool. In many cases they are not a “go-to” strategy. I’ve written this post not because 72(t) payments are a go-to strategy but rather because I know there are many in their 50s thinking about retirement but daunted by the prospect of accessing traditional retirement accounts prior to age 59 ½.

Generally speaking, I encourage using resources other than 72(t) payments if you are able to. They include:

Taxable Accounts: This video discusses why I’m so fond of spending down taxable accounts first in early retirement.

Inherited Retirement Accounts: Withdrawals from inherited retirement accounts (other than those the spouse treats as their own) are never subject to the 10% early withdrawal penalty. Often they are subject to a 10-year draw down rule, so usually they should be accessed prior to implementing a 72(t) payment plan from one’s own accounts.

Rule of 55 Distributions: Only available from a qualified retirement plan such as a 401(k) from an employer the employee separates from service no sooner than the beginning of the year they turn age 55. This is a great workaround from the early withdrawal penalty, and much more flexible than a 72(t) payment plan. But remember, the money must stay in the workplace retirement account (and not be rolled over to a traditional IRA) to get the benefit. 

Governmental 457(b) Plans: Withdrawals from governmental 457(b) plans are generally not subject to the 10% early withdrawal penalty. 

Roth Basis: Old annual contributions and conversions that are at least 5 years old can be withdrawn from Roth IRAs tax and penalty free at any time for any reason.

I previously discussed using a 72(t) payment plan to bail out Roth IRA earnings penalty-free prior to age 59 ½. This is a tactic that I would not recommend unless absolutely necessary (which I believe is a very rare situation). 

72(t) Landscape Change

It should be noted that the issuance of Notice 2022-6 in early 2022 changed the landscape when it comes to 72(t) payments. Before the 5 percent safe harbor, it was possible that taxpayers could be subject to sub-0.5 percent interest rates, meaning that it would take almost $1M in a retirement account to generate just $30,000 in an annual payment in one’s mid-50s. Now with the availability of the 5 percent interest rate much more modest account balances can be used to generate significant 72(t) payments in one’s mid-50s. 

Resources

Cody Garrett, CFP(R), and I wrote Tax Planning To and Through Early Retirement. The book goes into detail on early retirement withdrawal strategies. 

Natalie B. Choate’s treatise Life and Death Benefits for Retirement Planning (8th Ed. 2019), frequently referenced above, is an absolutely invaluable resource regarding retirement account withdrawals.

Sean Mullaney, What are the Risks of a 72(t) Payment Plan?, an article that goes into detail on the risks presented by a 72(t) payment plan and ways to mitigate those risks.

Correction

The previous version of this post published in November 2023 incorrectly used 30.6 as the age 57 factor in one of the calculations. The correct factor is 29.8. I regret the error. 

FI Tax Guy can be your financial planner! Find out more by visiting mullaneyfinancial.com

Follow me on LinkedIn: @SeanWMullaney

This post is for entertainment and educational purposes only. It does not constitute accounting, financial, investment, legal, or tax advice. Please consult with your advisor(s) regarding your personal accounting, financial, investment, legal, and tax matters.Please also refer to the Disclaimer & Warning section found here.

The Spousal IRA

Is earned income required to contribute to an individual retirement account (an “IRA”)? If you’re married, it may not be, thanks to the Spousal IRA. 

The Spousal IRA is a great opportunity for families to build financial stability, and perhaps get a juicy tax deduction, even if only one of the spouses work outside of the home. It can help families save for the future, qualify for Premium Tax Credits, and prioritize important goals such as raising children.

IRA Basics

There are two types of IRAs that most working Americans can consider. I did a primer about them here.

A traditional IRA offers tax-deferred growth and the possibility of a tax deduction for contributions. While distributions from a traditional IRA in retirement are taxable, many will find that traditional IRA distributions in retirement are only lightly taxed. 

A Roth IRA offers no tax deduction on the way in, but features tax-free growth and tax-free withdrawals in retirement. 

Both can be a great way to build up tax-advantaged wealth for retirement.

IRA Contribution Limits

The limit on IRA contributions for 2025 is the lesser of $7,000 or earned income ($8,000 or earned income if you are age 50 or older in 2025). The limit on IRA contributions for 2026 is the lesser of $7,500 or earned income ($8,600 or earned income if you are age 50 or older in 2026). Remember that traditional IRAs and Roth IRAs share that contribution limit, so a dollar contributed to a traditional IRA is a dollar that cannot be contributed to a Roth IRA and vice-versa. 

IRA Contribution Deadlines

Generally speaking, the deadline to contribute to either a traditional IRA or a Roth IRA is April 15th of the following year. The deadline cannot be extended even if the taxpayer files for an extension to file their own tax return. On rare occasions the IRS may provide a very limited exception to the April 15th IRA contribution deadline. 

The Spousal IRA

For purposes of having earned income allowing one to make an IRA contribution (tradition and/or Roth), a non-working spouse can use their spouse’s earned income for purposes of making either (or both) a traditional IRA or a Roth IRA contribution.

Here is an example:

Joe and Mary are married. Joe has a W-2 job and Mary does not. Mary can make an IRA contribution (a Spousal IRA) based on Joe’s W-2 earned income. 

The Spousal IRA can be used to increase tax-advantaged retirement savings. It can also be used to strategically optimize tax deductions. Many W-2 workers are covered by a workplace 401(k) plan. Thus, based on low income limits, it is difficult for them to deduct a traditional IRA contribution. 

However, when one is not covered by a workplace retirement plan, it is much easier to qualify to deduct a traditional IRA contribution. It is often the case that a Spousal IRA will offer a potential tax deduction when the working spouse is not able to deduct a traditional IRA contribution. 

IRA Contributions to Increase Premium Tax Credits

For early retirees, planning for the Premium Tax Credit in order to save thousands of dollars on ACA medical insurance premiums can be a challenge. This is particularly true in 2026 with the return of the 400 percent of federal poverty level cliff. A dollar of income over the 400 percent of federal poverty level cliff could cause a married couple $10,000 of Premium Tax Credits.

One tool in the tool box of those with side hustles or part time jobs in early retirement is the deductible traditional IRA contribution. An example can illustrate how a married couple could use deductible traditional IRA contributions, including a deductible spousal IRA contribution, to qualify for thousands of dollars of Premium Tax Credits. 

Larry and Cheryl, both age 55, are retired in 2026. They have capital gains, interest, and dividends in 2026 of $80,000. Cheryl works part time and earns $20,000 in W-2 income. She is not covered by a workplace retirement plan. 

Larry and Cheryl’s $100,000 of adjusted gross income puts them above 400% of the 2025 federal poverty level ($84,600). However, they can each make a deductible $8,600 traditional IRA contribution. Larry’s deductible traditional IRA contribution is a Spousal IRA. 

Those deductible contributions lower Larry and Cheryl’s adjusted gross income to $82,800, allowing them to qualify for thousands of dollars of Premium Tax Credits for 2026. 

Split-Year Spousal IRA Contribution Example

As I write this, the 2026 tax return season (for 2025 tax returns) is about to get started. Now’s the time to be thinking about 2025 IRA contributions if you have not yet made one!

There’s still plenty of time to contribute to an IRA (traditional or Roth) for the year 2025. Some of that planning might involve strategically employing a Spousal IRA. Here’s an example:

Mark and Theresa, both age 41, are married and have three children. They live in California. Mark works a W-2 job and Theresa does not have earned income. Mark is covered by a 401(k) at work. Their modified adjusted gross income (“MAGI”) for 2025 is $200,000. This puts them in the 22% marginal federal income tax bracket and the 9.3% marginal California income tax bracket. They have made no IRA contributions for either of them for 2025 going into tax season. 

It is early April 2026 and Mark and Theresa are about to file their tax returns. They see they have $9,000 in cash available to use to make 2025 IRA contributions. What they might want to do is contribute $7,000 to a 2025 deductible traditional IRA for Theresa (a Spousal IRA) and the remaining $2,000 to a 2025 Roth IRA for Mark, since he cannot deduct a traditional IRA contribution. By prioritizing a tax deduction, Mark and Theresa save $2,191 on their 2025 income taxes. 

The Spousal IRA as a Backdoor Roth IRA

The Spousal IRA can be executed as a Backdoor Roth IRA. Here is an example:

Jack and Betty, both age 42, are married. Jack works a W-2 job and Betty does not have earned income. Jack is covered by a 401(k) at work. Their MAGI for 2026 is $265,000 and thus neither of them qualify to make a regular annual contribution to a Roth IRA. 

Assuming Betty has no balances in traditional IRAs, SEP IRAs, and SIMPLE IRAs (and thus does not have a Pro-Rata Rule problem), Betty can contribute $7,500 to a nondeductible traditional IRA and then convert that amount (plus any growth) to a Roth IRA. Doing so uses a Spousal IRA to implement a Backdoor Roth IRA. 

Spousal IRA Tax Return Reporting

To report a deductible traditional Spousal IRA contribution, the amount of the contribution must be reported on Schedule 1, line 20, filed with the couple’s annual federal income tax return. 

To report a nondeductible traditional Spousal IRA contribution, the amount of the contribution must be reported on Part I of the Form 8606.

There is no required federal income tax return reporting for a Roth Spousal IRA contribution. However, such contributions should be entered into the tax return software to help determine the potential eligibility for a retirement savers’ credit. 

Conclusion

The Spousal IRA creates a great opportunity for married couples to save for retirement and possibly gain access to valuable tax deductions. It can help married couples focus on important priorities such as child rearing and still make significant contributions to retirement accounts. For the early retired with small amounts of earned income, it can help reduce income in order to qualify for a Premium Tax Credit or increase the amount of a Premium Tax Credit. 

FI Tax Guy can be your financial planner! Find out more by visiting mullaneyfinancial.com

Follow me on LinkedIn at @SeanWMullaney

This post is for entertainment and educational purposes only. It does not constitute accounting, financial, legal, or tax advice. Please consult with your advisor(s) regarding your personal accounting, financial, legal, and tax matters. Please also refer to the Disclaimer & Warning section found here.

The Widow’s Tax Trap and RMDs

People worry about taxation in retirement. In particular, they worry about the taxation of required minimum distributions (RMDs), especially after the death of a spouse. Widows find themselves in the single tax brackets after decades of enjoying the more favorable married filing jointly tax brackets. 

Widows and widowers finding themselves as single taxpayers is often referred to as the Widow’s Tax Trap. 

RMDs require taxable withdrawals from traditional retirement accounts such as IRAs and 401(k)s. But just how bad are they when a widow or widower is in the Widow’s Tax Trap?

Let’s unpack just how bad the combination of the Widow’s Tax Trap and RMDs is for an 81 year-old widow with a very tax inefficient structure: almost $3.7 million of her approximately $4.5 million of financial wealth in a traditional IRA.

My experience tells me many financial planners and gurus will tell you this is a terrible outcome. That $3.7 million traditional IRA is infested with taxes!

But is it really?

81 Year-Old Widow in the Widow’s Tax Trap

I put together an analysis of an affluent widow in the Widow’s Tax Trap. Let’s call her Jane. Her traditional IRA causes her to have an RMD of almost $190,000. Wow!

Grab the tax analysis file here!

To be fair, most Americans will never have a $3.7 million traditional IRA and/or a $190K RMD. But I analyze them to demonstrate “what if the widow is highly inefficient from a tax perspective?”

What are the federal income tax rates on that feared RMD? 

Isn’t it remarkable that an 81 year-old widow with almost $3.7 million in a traditional IRA has more of her RMD taxed in the 12 percent tax bracket than in the 32 percent tax bracket?

Despite all the fear of taxation of RMDs, that’s the reality when it comes to a very affluent, very inefficient 81 year-old widow. 

Some might say “but what about IRMAA?” “What about the net investment income tax?”

Yes, Jane pays IRMAA of approximately $6,500 in two years because of her RMDs. And yes, the RMDs trigger approximately $500 of net investment income tax.

But do either of these have any impact on Jane’s lived experience and financial success?

Absolutely not!

The government scores some Garbage Time Touchdowns on Jane by collecting some IRMAA, some net investment income tax, and some income tax in the 32 percent bracket. 

A Garbage Time Touchdown is a late in the game touchdown scored by a team that will lose the game regardless of the touchdown. As a New York Jets fan, sadly I’m an expert in Garbage Time Touchdowns.

Jane has some tax inefficiencies that are just Garbage Time Touchdowns.

Think about the lifetime arc of Jane’s taxes in today’s tax planning world:

  • As a single individual, Jane likely deducted workplace retirement plan contributions at a 22, 24, or 32 percent rate. Win versus the IRS!
  • As a married couple, Jane and her husband likely deduct into workplace retirement plans at a 22 or 24 percent rate. Win versus the IRS!
  • In early retirement, they live off taxable accounts and do not do Roth conversions. They may pay nothing in federal income tax! Win versus the IRS!
  • Once taxable accounts are depleted, traditional retirement account distributions could have benefitted from the Hidden Roth IRA. Win versus the IRS!
  • Even RMDs are likely subject to the 12 percent and 22 percent brackets while they are both alive. Win versus the IRS!
  • As a widow, the relatively minor tax inefficiencies creep in. These are Garbage Time Touchdowns. 

This arc, which eschewed Roth 401(k) contributions and taxable Roth conversions, screams “Jane wins a blow out victory over the IRS” over the course of her lifetime. 

Sure, at the end Jane gave up some Garbage Time Touchdowns to the IRS, but not after decades of defeating the IRS. 

What’s more important than winning the spreadsheet is lived experience. Notice that Jane paying 32 percent on about six percent of her RMD has $200K of after-tax cash flow? 

In order for the Widow’s Tax Trap to bite hard, the widow generally has to have about $200K or more of after-tax cash flow.

The taxes bite when widows can most afford them!

Watch me break down the tax analysis of our 81 year-old widow on YouTube.

Roth Conversions to Avoid the Widow’s Tax Trap

Should Jane and her husband have done taxable Roth Conversions in retirement to avoid the widow paying 32 percent federal income tax on some of her RMDs?

Here vocabulary becomes very important. Yes, some taxable Roth conversions taxed at 22 percent or 24 percent could have been beneficial. But they were hardly necessary.

Outside of cases where taxable Roth conversions create enough required income to qualify for a Premium Tax Credit, taxable Roth conversions are not necessary. 

Yes, there are times where large taxable Roth conversions can be beneficial in that they mitigate harmful effects of the Widow’s Tax Trap. But the analysis above shows that the harmful effects of the Widow’s Tax Trap aren’t all that harmful for the vast, vast, vast majority of Americans. This is true even those with most of their financial wealth in traditional retirement accounts. 

Why would Jane and her husband prioritize large scale taxable Roth conversions to avoid having six percent of her RMDs as a widow being subject to the 32 percent tax bracket? 

Further Reading

The tax planning landscape has changed. One resource that puts aside the fear and realistically tackles today’s tax and retirement planning landscape is Tax Planning To and Through Early Retirement, a book I’m proud to have co-authored with Cody Garrett. 

FI Tax Guy can be your financial planner! Find out more by visiting mullaneyfinancial.com

Follow me on LinkedIn: @SeanWMullaney

This post is for entertainment and educational purposes only. It does not constitute accounting, financial, investment, legal, or tax advice. Please consult with your advisor(s) regarding your personal accounting, financial, investment, legal, and tax matters. Please also refer to the Disclaimer & Warning section found here.

2026 Backdoor Roth IRA Timing

Merry Christmas and Happy New Year!

The Christmas season (ending January 11th this year) coincides with the beginning of personal finance’s Backdoor Roth IRA season. 

Many readers look forward to New Year’s Day not to watch the Rose Bowl but rather to contribute to a traditional IRA, the first step of the Backdoor Roth IRA. 

The question then becomes: how long should I wait to do the second step of the Backdoor Roth IRA, the conversion of the traditional IRA contribution and any small growth to a Roth IRA?

Below I discuss my views on the matter as they apply to 2026 Backdoor Roth IRAs. 

Backdoor Roth IRA Timing Concerns

The Backdoor Roth IRA involves three accounts and two steps. First, the investor transfers money from a bank account (A) to a traditional IRA (B) as a regular annual contribution to the traditional IRA. Second, the investor converts the entire traditional IRA balance to a Roth IRA (C).

Written out logically, the Backdoor Roth IRA sequence is as follows:

A→B→C

The question is “do we respect the transfer to B or do we disregard the transfer to B and say, instead, that there was a single transfer from A to C?

Michael Kitces, in 2015, wrote an article stating that he was, at that time, concerned that, if the Roth conversion step was done close in time to the traditional IRA contribution, the transfer to the traditional IRA would be disregarded. For high income individuals, this would create an excess contribution to a Roth IRA subject to a 6% annual penalty.

I do not share his concern. My perception is that most financial planners, financial advisors, and tax return preparers also do not share his concern. 

My Approach

I wrote a detailed blog post stating that I do not believe the step transaction doctrine invalidates the Backdoor Roth IRA. Of particular note is Section 408(d)(2)(B), which provides that all IRA distributions (including Roth conversions) during the year are aggregated into a single distribution. 

This rule tells us that timing within the year is irrelevant for determining tax treatment. Why would a judicial doctrine change the Backdoor Roth IRA’s tax treatment based on a timing concern when the Code itself says timing is irrelevant? 

Favored Backdoor Roth IRA Timing

Here is my favored approach: Make the traditional IRA contribution at any time during a particular month and then wait until the following calendar month to do the Roth conversion step. Usually the traditional IRA is invested in a low yielding stable cash or cash equivalent type of asset, creating a small bit of income in between the two steps. 

Here is how that plays out with an example:

Keith, age 47, wakes up on New Year’s Day 2026 and contributes $7,500 to a traditional IRA invested in a money market fund. On February 2, 2026, when the traditional IRA has grown to $7,525, he converts all of it to a Roth IRA. 

Yes, Keith could have converted the $7,500 to a traditional IRA on January 2, 2026. I would strongly argue that he has a good Backdoor Roth IRA in that scenario.

But my favored approach is for him to wait until February. Why not? What’s the downside to my favored approach? Practically none. My favored approach increases Keith’s taxable income by $25, which is obviously no big deal. It also buys Keith a bit more protection against the step transaction doctrine concern (which, admittedly, I believe to be a minimal concern). 

Backdoor Roth IRA Diligence

Allow me to touch on two important diligence points when doing the Backdoor Roth IRA.

The first is to ensure that as of December 31st of the year of any Roth conversion step (so 2026 in Keith’s example), it is important to have $0 (or close to $0) in all traditional IRAs, SEP IRAs, and SIMPLE IRAs. For more discussion as to why that’s important, see this post. 

Second, it is important to properly complete the Form 8606 and file it with the annual federal income tax return. This post has an example of how a Form 8606 is completed to reflect a Backdoor Roth IRA. 

Further Reading

In early 2026 many Americans will find they made too much to have made their 2025 Roth IRA contribution. Having contributed in 2025, they now need to remedy the overcontribution. Further, they may still want to do a Backdoor Roth IRA for 2025 in 2026, what I refer to as a Split-Year Backdoor Roth IRA. 

Read here to find out my favored approach when facing this situation. 

FI Tax Guy can be your financial planner! Find out more by visiting mullaneyfinancial.com

Follow me on LinkedIn at @SeanWMullaney

This post is for entertainment and educational purposes only. It does not constitute accounting, financial, legal, investment, medical, or tax advice. Please consult with your advisor(s) regarding your personal accounting, financial, legal, investment, medical, and tax matters. Please also refer to the Disclaimer & Warning section found here.

The Backdoor Roth IRA After an Excess Contribution to a Roth IRA

It happens all the time. People contribute to a Roth IRA only to find out at tax time they made too much income to have made the Roth IRA contribution. 

There are two primary ways to correct this situation. They are a recharacterization and a corrective distribution. Both are entirely valid remedial paths when it turns out that one contributed to a Roth IRA and their income was too high to have done so. 

But which remedial path makes the most sense if the investor wants to also do a Backdoor Roth IRA for the year in question?

As I am posting this in late 2025, this is about to become very relevant as applied to excess Roth IRA contributions occurring in 2025. Many will find out in early 2026 as they work through their 2025 tax return that they did not qualify for a previously made 2025 Roth IRA contribution. 

Below I explore this topic with two examples. 

Recharacterization

Let’s consider Rich and Rebecca, married and both age 48 in 2025. At least one of them was covered by a workplace retirement plan in 2025. Rich and Rebecca each contributed $7,000 to a Roth IRA on January 2, 2025 anticipating their 2025 modified adjusted gross income would be approximately $225,000. Due to a year-end bonus and unexpected capital gains distributions, their 2025 MAGI turned out to be $250,000, which they discovered after talking to their income tax return preparer in February 2026. 

Having exceeded the 2025 Roth IRA MAGI contribution limit of $246,000, they need to remedy the situation. Since neither of them has any balance in a traditional IRA, SEP IRA, and/or SIMPLE IRA, they are also interested in doing a Backdoor Roth IRA for 2025 (what I refer to as a Split-Year Backdoor Roth IRA). 

They proceed as follows. First, they ask their financial institution to recharacterize their 2025 Roth IRA contributions and related earnings ($550 in Rich’s case, $600 in Rebecca’s case) as traditional IRAs in late February 2026. This event does not create any 2025 or 2026 taxable income. 

Second, in early March 2026, Rich converts the balance in his traditional IRA, now $7,560, from his traditional IRA to a Roth IRA. Likewise, Rebecca converts the balance in her traditional IRA, now $7,612 from her traditional IRA to a Roth IRA. This creates $560 of 2026 taxable income for Rich and $612 of 2026 taxable income for Rebecca. 

Both Rich and Rebecca have $0 balances in all traditional IRAs, SEP IRAs, and SIMPLE IRAs as of December 31, 2026. 

I believe that it’s helpful to illustrate the sequence logically using letters. A is a checking account, B is a traditional IRA, and C is a Roth IRA.

Here is how the entire sequence looks when Rich and Rebecca first contribute to a Roth IRA, correct it through a recharacterization, and then do the Split-Year Backdoor Roth IRA. 

A→C→B→C

Corrective Distribution

Let’s consider Carl and Debbie, married and both age 47 in 2025. At least one of them was covered by a workplace retirement plan in 2025. Carl and Debbie each contributed $7,000 to a Roth IRA on January 2, 2025 anticipating their 2025 modified adjusted gross income would be approximately $225,000. Due to a year-end bonus and unexpected capital gains distributions, their 2025 MAGI turned out to be $255,000, which they discovered after talking to their income tax return preparer in February 2026. 

Having exceeded the 2025 Roth IRA MAGI contribution limit of $246,000, they need to remedy the situation. Since neither of them has any balance in a traditional IRA, SEP IRA, and/or SIMPLE IRA, they are also interested in doing a Backdoor Roth IRA for 2025. 

They proceed as follows. First, they ask their financial institution to send them a corrective distribution of their 2025 Roth IRA contributions and related earnings ($650 in Carl’s case, $700 in Debbie’s case) in late February 2026. 

The February 2026 corrective distribution of the excess Roth IRA contributions and related net income attributable to the returned contributions creates taxable income of $650 to Carl and $700 to Debbie in 2025 to be reported on their soon-to-be-filed 2025 federal income tax returns. See Section 408(d)(4)(C), Treas. Reg. Sec. 1.408A-6 Q&A 1(d), and this Vorris J. Blankenship article. 

Second, in late February 2026, both Carl and Debbie make a $7,000 contribution to their traditional IRAs and code the contribution as being for 2025. 

Third, Carl converts the balance in his traditional IRA, now $7,010, from his traditional IRA to a Roth IRA. Likewise, Debbie converts the balance in her traditional IRA, now $7,010, from her traditional IRA to a Roth IRA. This creates $10 of 2026 taxable income for Carl and $10 of 2026 taxable income for Debbie. 

Both Carl and Debbie have $0 balances in all traditional IRAs, SEP IRAs, and SIMPLE IRAs as of December 31, 2026. 

Here is how the entire sequence looks when Carl and Debbie first contribute to a Roth IRA, correct it through a corrective distribution, and then do the Split-Year Backdoor Roth IRA. 

A→C→A→B→C

Critical Assessment

Let’s step back. Logically, what is the Backdoor Roth IRA? It boils down to the following formulation:

A→B→C

I and others have argued that “B” should be respected. I’m unaware that the IRS disagrees with this view. At this point, after a decade and a half of Backdoor Roth IRAs, it would be exceedingly odd for the IRS to start aggressively challenging the transaction. 

Assessing the Corrective Distribution Remedial Path

Viewed logically, the “corrective distribution followed by the Split-Year Backdoor Roth IRA” is just as strong as the Backdoor Roth IRA itself. It simply appends two additional transactions, an (ultimately excess) Roth IRA annual contribution followed by a corrective distribution. If one can defend the Backdoor Roth IRA, one should be able to defend the corrective distribution followed by the Split-Year Backdoor Roth IRA.

You might argue that the money was in a Roth IRA and ultimately ends up back in a Roth IRA. That can be true, though the investor need not use the exact same dollars received in the corrective distribution to initiate the later Split-Year Backdoor Roth IRA. 

Regardless, in order to “collapse” steps, the IRS would need to successfully defeat not one, but two, steps. First the IRS would need to successfully disregard the corrective distribution on which the investor most likely reports taxable income. Second, the IRS would need to disregard the transfer to the traditional IRA. 

The IRS has not aggressively tried to disregard a single step (the traditional IRA contribution) when it comes to the Backdoor Roth IRA transaction for the past 15 years. It’s difficult to imagine the IRS would try to aggressively disregard two distinct steps, which is what it would take to defeat the “corrective distribution followed by the Split-Year Backdoor Roth IRA” path. 

Assessing the Recharacterization Remedial Path

Where I get much more concerned is the “recharacterization followed by the Backdoor Roth IRA” path. 

In all of these analyses, the key issue is “do we respect “B”?” Recall the recharacterization followed by the Backdoor Roth IRA formulation:

A→C→B→C

Notice what’s on both sides of B? 

C!

We have a case where funds are in a Roth IRA, temporarily rest in a traditional IRA, and then end up right back in a Roth IRA. 

Yes, the Internal Revenue Code allows recharacterizations. But could the IRS successfully disregard a recharacterization into a traditional IRA when both immediately before and immediately after those funds are in a Roth IRA?

I believe that a recharacterization followed by a Split-Year Backdoor Roth IRA dramatically increases the risk to the investor. The risk is that the recharacterization would be disregarded, exposing the investor to the annual 6% excess Roth IRA contribution penalty. 

Favored Approach

I strongly favor the corrective distribution remedial path if one is looking to do a Backdoor Roth IRA after having made an excess contribution to the Roth IRA for the year.

What are the drawbacks to my favored approach? It requires three steps instead of two, since the investor must initiate the corrective distribution, contribute to a traditional IRA, and then convert the traditional IRA. 

Further, my favored approach generally accelerates the tax on the “net income attributable” to the excess contribution. Recall Rich and Rebecca pay that tax in 2026 while Carl and Debbie pay practically all of that tax with their 2025 federal income tax returns. 

My favored approach generally does not increase the small tax created by the combination of the remediation and the Split-Year Backdoor Roth IRA. It simply accelerates it by one year. In a low yield world, that is a tiny drawback. 

I believe that the corrective distribution remedial path is very strong. I do not believe that the IRS would stand a very good chance of disregarding two steps to create an excess contribution to a Roth IRA. Further, I believe that respecting time spent in a traditional IRA is much more challenging when that money is in a Roth IRA immediately before and immediately after being in the traditional IRA. 

When both corrective distributions and recharacterizations are available to those looking to ultimately do a Backdoor Roth IRA, why not choose the corrective distribution path? 

Finally, note that this blog post is not advice for you or anyone else. I am not writing that the recharacterization remedial path cannot work. Rather, I am, in an academic sense, simply stating two things.

First, the recharacterization followed by a Split-Year Backdoor Roth IRA path increases the risk to the investor.

Second, the corrective distribution path appears to be preferable to the recharacterization path if one is looking to do the Split-Year Backdoor Roth IRA after an excess contribution to the Roth IRA for the same year. 

The Real Answer

Congratulations on reading a blog post that should not exist! The real answer to this issue isn’t my analysis. Rather, it is for Congress to eliminate the MAGI restriction on the ability to make an annual Roth IRA contribution. This would align American rules with Canadian rules. 

FI Tax Guy can be your financial planner! Find out more by visiting mullaneyfinancial.com

Follow me on LinkedIn at @SeanWMullaney

This post is for entertainment and educational purposes only. It does not constitute accounting, financial, legal, investment, medical, or tax advice. Please consult with your advisor(s) regarding your personal accounting, financial, legal, investment, medical, and tax matters. Please also refer to the Disclaimer & Warning section found here.

2026 ACA Premium Tax Credits: Embrace Solutions!

Fear is prevalent.

ACA Premium Tax Credits are going away!!!

The 400 percent cliff will ruin your early retirement!!!

Neither of these is true. But the messages are out there.

Yes, the Premium Tax Credit for 2026 is very unsettled. Could it create problems for early retirees in 2026? Yes.

But now is the time to embrace solutions, to borrow a phrase from Jon Taffer. 

Since 2026 ACA open enrollment begins in less than a week, below I assess the lay of the land for ACA medical insurance and Premium Tax Credits in 2026. I then move onto planning as early retirees consider their ACA medical insurance options for 2026 in late 2025.

Premium Tax Credit

From 2014 through 2020, the Premium Tax Credit reduces ACA medical insurance premiums based on this table. Of note is that this table fully eliminates Premium Tax Credits once one’s income is over 400 percent of the federal poverty level. I refer to the years 2014 through 2020 as the “First Era.”

From 2021 through 2025, the Premium Tax Credit reduces ACA medical insurance premiums based on this more generous table. Of note is that this table ratably reduces, but does not eliminate, Premium Tax Credits once one’s income is over 400 percent of the federal poverty level. I refer to the years 2021 through 2025 as the “Second Era.”

With no change to the laws, in 2026 we start what I refer to as the “Third Era.” The Premium Tax Credit will be determined based on the First Era table. The enhancements to ACA Premium Tax Credits will go away. ACA Premium Tax Credits themselves will not go away. 

Fears Over Changes to the Premium Tax Credit

If we look at history, we know that the 400 percent of federal poverty level cliff will not ruin an early retirement.

Why?

We saw from 2014 through 2020 plenty of Americans were successfully early retired. Many of them got Premium Tax Credits.

Yes, the First Era featured the 400 percent of federal poverty level cliff. Yes, that was a financial planning issue for early retirees to deal with. No, it did not ruin their early retirement. 

Further, medical insurance premiums are simply one of many financial planning issues early retirees deal with. It’s odd to claim that a change to one expense in 2026 will destroy a retirement plan.

The Government Shutdown

Currently, many federal government agencies are either closed or working with reduced operations. This is commonly referred to as the “Government Shutdown.”

The Government Shutdown provides a potential leverage point for politicians to extend a version of the enhanced Premium Tax Credits. Democrats generally want to make the Second Era Premium Tax Credit enhancements permanent. Interestingly enough, there are two Republican cohorts that also want to extend some version of enhanced Premium Tax Credits. One is a baker’s dozen of generally Blue State Republicans in the House and one are more populist Republicans led by Representative Marjorie Taylor Greene. 

There are no guarantees. It is absolutely possible that some version of enhanced Premium Tax Credits will apply in 2026. However, from a planning perspective, early retirees should consider the very real possibility that we go back to the First Era Premium Tax Credit rules in 2026.

2026 Premium Tax Credit Solutions

One year’s medical insurance premiums are not likely to ruin anyone’s early retirement and finances. 

That being said, early retirees should approach the situation by embracing solutions.

To my mind, for those looking to improve their tax and ACA medical insurance premium picture in 2026, as of late October 2025 there are two primary paths. The first path is “Bronze Plan and Lower Income” and the second path is “Catastrophic Plan and Lower Premiums.”

Bronze Plan and Lower Income

I have previously said that in the new planning environment, Bronze is Gold. 

For many early retirees, Bronze ACA plans will be very desirable in 2026. Why? First, the premiums are lower than Platinum, Gold, and Silver plans, reducing pressure on the Premium Tax Credit issue. 

Second, beginning in 2026 all Bronze plans will qualify as “high deductible health plans” allowing deductible HSA contributions. This allows early retired enrollees to deduct their HSA contributions, possibly increasing their Premium Tax Credit and possibly ducking under the 400 percent of federal poverty level cliff. 

Third, this sets up a tax free pot of money from which to pay medical expenses in 2026. From a Premium Tax Credit perspective, it’s better to reach into a tax free pot than to fund medical expenses by selling a capital gain asset or taking a taxable distribution from a traditional IRA.

A component of Bronze is Gold planning is keeping taxable income low. One helpful tactic in this regard is to hold all taxable bonds in traditional retirement accounts. This keeps interest income off one’s tax return, reducing Premium Tax Credit damage that taxable bond interest can do. 

Cody Garrett and I anticipated that keeping income low for Premium Tax Credit purposes would be a big issue in 2026 when we wrote Tax Planning To and Through Early Retirement. That’s why, on pages 176 and 177 of the paperback version, we include 8 tactics early retirees might be able to use to lower their income in 2026 and increase their Premium Tax Credit. 

Catastrophic Plan and Lower Premiums

A little-noticed change in September 2025 can be very helpful to those thinking about enrolling in ACA medical insurance in November 2025 for 2026.

The government now allows those with incomes above 400 percent of the federal poverty level to enroll in an ACA Catastrophic medical insurance plan. Previously, catastrophic plans were mostly open only to those under age 30 or could otherwise demonstrate a hardship. Now the rules allow having income over 400 percent of federal poverty level to qualify as having a hardship, and thus enroll in Catastrophic coverage.

I believe that Catastrophic coverage is an option well worth considering for many early retirees. Catastrophic policies generally have no coinsurance to start, but they do have in-network annual out-of-pocket maximums. To my mind, that latter feature is, by far, the most important benefit of a medical insurance policy–avoidance of financial ruin in the event of significant medical expenses. 

Further, Catastrophic plans generally have lower premiums than Bronze plans, perhaps significantly lower. Note this can vary significantly based on age and geography.

Those on a Catastrophic plan do not qualify for a Premium Tax Credit. That can be a feature rather than a bug if you’re likely to be near the 400 percent of federal poverty level cliff anyways. Being on a Catastrophic plan makes Roth conversions much more desirable. With no Premium Tax Credit to manage for, the early part of an early retirement becomes a much more desirable time to do Roth conversions.

In today’s planning environment, I’m generally conservative when it comes to Roth conversions when one is on an ACA medical insurance plan. Why do Roth conversions when you are subject to what are essentially two federal income taxes; the federal income tax itself and the possible reduction or elimination of the Premium Tax Credit?

Catastrophic plan enrollment can open the door to more potentially beneficial Roth conversions.

Note that starting in 2026 all Catastrophic plans will qualify as high deductible health plans, allowing deductible HSA contributions. These deductions can help with Roth conversion and other tax planning.

Conclusion

Think twice when you hear fearful messages about 2026 Premium Tax Credits. For early retirees, now is the time to plan and embrace solutions. It’s also time to keep one’s ear to the ground. It’s possible that eventually some version of the Second Era’s Premium Tax Credit enhancements will ultimately be enacted.

FI Tax Guy can be your financial planner! Find out more by visiting mullaneyfinancial.com

Follow me on LinkedIn at @SeanWMullaney

This post is for entertainment and educational purposes only. It does not constitute accounting, financial, legal, investment, medical, or tax advice. Please consult with your advisor(s) regarding your personal accounting, financial, legal, investment, medical, and tax matters. Please also refer to the Disclaimer & Warning section found here.

Tax Planning To and Through Early Retirement Launch Day

It’s finally here! Tax Planning To and Through Early Retirement launches today, September 23rd. It’s available at Amazon and other online retailers.

To mark the occasion, we discussed the book on yesterday’s episode of the ChooseFI podcast and today’s episode of the BiggerPockets Money podcast.

We will be on several more podcasts in the coming weeks and months discussing the book and its concepts. 

One I’m particularly excited about is this Friday’s BiggerPockets Money podcast episode where we discuss tax planning for the five phases of retirement drawdown. You can find that episode on September 26th on the BiggerPockets Money YouTube channel and on podcast players.

I have also put two special YouTube videos on my YouTube channel discussing concepts from the book. 

  • Today I posted a video discussing just how much tax a retired married couple might pay on a $40,700 Roth conversion using an example from the book. You might be very pleasantly surprised by the result.

A Favor Request

I speak for both Cody and myself when I say we are grateful for all of the support we have received for this project.

If you have purchased the book and read it, we humbly for one more favor. Please write an honest and objective review of the book on Amazon. The number and quality of reviews is vital to the book remaining one that Amazon recommends to its customers. 

We want to get word out about Tax Planning To and Through Early Retirement. You can help us do that with an Amazon review! 

Thank you for considering our request.

FI Tax Guy can be your financial planner! Find out more by visiting mullaneyfinancial.com

Follow me on LinkedIn: @SeanWMullaney

This post is for entertainment and educational purposes only. It does not constitute accounting, financial, investment, legal, or tax advice. Please consult with your advisor(s) regarding your personal accounting, financial, investment, legal, and tax matters. Please also refer to the Disclaimer & Warning section found here.

The Middle Class Trap

I have said the tax laws want you to retire early. 

Counter to that point, the BiggerPockets Money podcast has warned that the tax laws are an effective bar to many retiring prior to age 59 ½.

So who is right? The FI Tax Guy or Scott Trench and Mindy Jensen of the BiggerPockets Money podcast?

This isn’t just a discussion in my mind or a late night debate at the Waffle House. It’s become a debate in the financial independence space. Just last week, the Middle Class Trap was the topic of the ChooseFI podcast. 

We will return to that episode of ChooseFI later. For now, I want to start by defining the Middle Class Trap and providing the two reasons I don’t believe the Middle Class Trap is a trap. Then I will move onto several numerical examples, including four Mindy Jensen provided on ChooseFI. 

The Middle Class Trap Defined

Scott Trench and Mindy Jensen walk through their definition of the Middle Class Trap from in this YouTube video. I encourage you to watch it.

Boiled down, the argument is that primary residence wealth is trapped and traditional retirement accounts are trapped until age 59 ½. Thus, many in the middle class have trapped wealth and cannot retire prior to age 59 ½ despite good numbers on paper.

There are two problems with their argument. First, primary residence wealth isn’t the owner’s wealth as we ordinarily conceive and define it. Second, traditional retirement accounts are not trapped prior to age 59 ½. 

The Primary Residence Question

Too often we think of primary residences as investments. They are not, as Douglas Boneparth observes. They are a form of consumption.

People say “I have a million dollars in home equity so I am a millionaire.” 

No, you are not.

I can prove it.

Peter has a $500 checking account, a car, clothes, and a $1 million home with no mortgage. He sells the home for $1 million. He immediately must get a hotel room to sleep in tonight.

John has a $500 checking account, a car, clothes, rents an apartment, and has $1 million in VTSAX in a taxable account. He sells $10,000 of VTSAX for cash. He now has a pile of cash and need not make any adjustments to have a bed for the night. 

Is Peter’s home equity really his wealth when accessing causes significant life adjustments? John’s VTSAX is his wealth. His accessing it requires no life adjustments. 

So what then is market driven appreciation in home equity? It’s growth in asset value that primarily benefits three classes of people:

  1. The next generation
  2. Owners willing to change geographies or willing to significantly downsize
  3. Owners needing long-term care at the end of life

Market driven increases in home equity are not a trap. Rather, they are wealth that, in many cases, someone else gets to enjoy.

Imagine I’m writing a blog post and the doorbell rings. I answer and the delivery man says, “Mr. Mullaney, congratulations! You won a contest. The prize is $1,000 of Blippi toys!”

Those Blippi toys are my wealth that my toddler Goddaughter gets to enjoy. 

It’s no different with market driven increases in home equity. It’s wealth that shows up on your doorstep that most likely will be enjoyed by the next generation. 

In no way do those Blippi toys trap me. Same with market driven increases in home equity. 

The 10% Early Withdrawal Penalty is No Bar to Early Retirement

I’ve written about the myriad ways to fund retirement prior to 59 ½ without incurring the 10 percent early withdrawal penalty. I’ve spoken about it on two episodes of the ChooseFI podcast (475 and 491).

But until now, I have never explicitly said the following:

Those 50 and older with sufficient assets are in no way barred from early retirement due to the 10 percent early withdrawal penalty even if all of their financial asset wealth is in traditional retirement accounts. 

While 72(t) payment plans are not the ideal retirement plan, they are more than adequate enough to use to retire in the year one turns age 50 or later. Those 50 or older, with a simple spreadsheet and some diligence, are in no way barred from early retirement due to the 10 percent early withdrawal penalty. 

What about those under age 50? 

Few under age 50 will be able to retire on traditional retirement accounts alone because of sufficiency concerns. Tax concerns are not the problem when thinking about retiring prior to age 50 – it’s all about sufficiency!

Fortunately, the profile tends to resolve itself. To have enough financial wealth to retire in one’s 40s, the prospective early retiree most likely contributed to some combination of Roth accounts or taxable accounts prior to retirement. While not insignificant, traditional retirement account contribution limits are such that for many, it will be difficult to rely on them exclusively to build up sufficient assets for retirement prior to January 1st of the year of one’s 50th birthday. The 40-something early retiree can start their early retirement distributions from Roth accounts, taxable accounts, or a combination of both, obviously without penalty. 

Summed up, when assessing the Middle Class Trap, for those under 50, their profile itself usually resolves the issue. For those 50 and older, the 72(t) payment plan rules are so advantageous (due to a major change in 2022) that a spreadsheet requiring one amortization calculation, some coordination with a financial institution, and a bit of ongoing additional diligence resolves the issue. 

For both age cohorts, there is no tax trap. 

Does this mean the 10 percent early withdrawal penalty has been, in effect, repealed? Hardly! If someone like me, in their late 40s, wants to take $20,000 from a traditional 401(k) to fly round-trip in a suite, I will pay a hefty 10 percent early withdrawal penalty. The penalty is still effective to discourage impulsive onetime withdrawals before retirement. But the penalty is not effective to prevent early retirements with a systematic, sustainable withdrawal plan. That’s the obvious intention behind the series of substantially equal periodic payments exception.  

Examples from Mindy Jensen on ChooseFI Episode 543

Last week’s episode of the ChooseFI podcast, featuring host Brad Barrett, Mindy Jensen, and Can I Retire Yet blog author Chris Mamula was a great contribution to the FI space. 

During the ChooseFI episode, Mindy offered some numerical examples to argue for her case. That is a very legitimate tactic, and I personally love examples. Unfortunately, using numerical examples ran up against a limitation of the audio podcast format, since it can be difficult for participants and listeners to fully process multiple numbers while listening to an episode.

Mindy started sharing numerical examples around 25:00 in the podcast. I went back to the YouTube video and put Mindy’s numbers in the below table. I then added a row totaling financial assets and two rows laying out theoretically possible annual withdrawal rates. 

AmountPerson APerson BPerson CPerson D
Primary Residence Value or EquityNot givenNot given$3,000,000$800,000
Traditional Retirement Accounts$268,000$36,000$1,200,000$234,000
Roth Retirement Accounts$18,000$143,000$0$0
Taxable Brokerage Accounts$187,000$306,000$0$60,000
Cash$106,000$119,000$225,000$69,000
HSA$0$0$35,000$0
Total Financial Assets$579,000$604,000$1,460,000$363,000
Morningstar Annual SWR (3.7%)$21,423$22,348$54,020$13,431
Six Percent Annual Withdrawal Rate$34,740$36,240$87,600$21,780

Let’s use a range of withdrawal rates just for illustrative purposes. On the low end, we’ll use Morningstar at 3.7 percent, which can be fairly considered to be conservative. On the high end, let’s roll the dice a bit and use 6 percent.

Notice that the problem in the examples is not that the person has everything locked up in traditional accounts. The problem is sufficiency! Aside from Person C, it does not matter if all of the financial wealth is in Roth accounts, taxable accounts, or split between the two of them. 

Persons A, B, and D are not in the Middle Class Trap. Rather, they are in a situation where they need to work longer unless their annual spending is incredibly modest, even by financial independence standards. 

I believe that Person C could consider living on cash and later starting a 72(t) payment plan, but we really can’t tell without knowing much more information, including their age and their annual spending level in retirement. 

Middle Class Trap 72(t) Payment Plan Examples

In one podcast episode, Mindy and Scott put the parameters of the Middle Class Trap at $1M to $1.5M of trapped wealth (see 3:19 of this video). How bad is the federal income tax result if we assume practically all of that wealth is in traditional deferred retirement accounts?

Using the old Four Percent Rule of Thumb for our 72(t) annual payment at both ends of the spectrum, and assuming a $40,000 taxable savings account and 5 percent interest on it and on the annual 72(t) payment taken at the beginning of the year and spent evenly during the year, here’s the 2025 federal income tax result by my estimation.

Single $1MSingle $1.5MMarried $1MMarried $1.5M
Interest Income$3,000$3,500$3,000$3,500
72(t) Payment$40,000$60,000$40,000$60,000
AGI$43,000$63,500$43,000$63,500
Standard Deduction$15,000$15,000$30,000$30,000
Taxable Income$28,000$48,500$13,000$33,500
Federal Income Tax$3,122$5,584$1,300$3,543
72(t) Payment Funding for Expenses Other Than Federal Income Tax$36,878$54,416$38,700$56,457
Effective Federal Income Tax Rate7.26%8.79%3.02%5.58%
AGI as a Percent of 2025 Federal Poverty Level274.76%405.75%203.31%300.24%

I believe this table strongly supports my contention that the tax laws want you to retire early. Look how light the taxation is on 72(t) payments! 

You may ask “I thought federal tax rates started at 10 percent – how do these people pay effective rates less than that?” The answer is the standard deduction, which loves early retirees. Because of the standard deduction, all four taxpayers enjoy what I refer to as the Hidden Roth IRA. They take some amounts from their traditional IRAs and pay 0 percent federal income tax on them.

Is the 72(t) payment plan outcome perfect? No. Those on a 72(t) payment plan have to abide by the restrictions of the 72(t) payment plan rules. But those rules are not that bad, and allow for techniques to potentially increase or decrease the annual payment.

I will note two things. First, I am not arguing anyone should simply plan on getting to an early retirement age and have every last penny in traditional retirement accounts. I am arguing that it is hardly a trap if someone gets to age 50, has every penny in traditional retirement accounts, and wants to retire using a reasonable withdrawal rate.  

Second, managing for Premium Tax Credit can be a concern. At the high end of Mindy and Scott’s Middle Class Trap range, a single taxpayer would be shut out of a Premium Tax Credit (having gone a bit over the 400 percent of FPL cliff) if they were on an ACA medical insurance plan in 2026, unless later tax law changes in 2025 amend Section 36B. This person could turn on Premium Tax Credits by electing a slightly lower initial 72(t) annual payment. 

Sufficiency Is The Real Problem

We should spend more time on the real problem: retirement sufficiency. According to UBS, median adult wealth in the United States in 2023 was just $112,157. Even considering that older Americans are likely to have greater wealth than younger adults, the median wealth statistic means many Americans of all ages are significantly behind in retirement savings. The best way to catch up is by making traditional retirement account contributions. 

Update May 1, 2025

Thank you to Mindy Jensen who wrote a thoughtful response to this blog post. You can read it over at BiggerPockets.

Stay Tuned

This won’t be the last time you hear from me on this topic. Cody Garrett and I are currently writing Tax Planning To and Through Early Retirement, a book we hope to publish later this year. We will address all sorts of issues when it comes to accessing wealth and tax planning for those retiring prior to turning 59 ½.

What questions do you have about retiring prior to 59 ½? Let us know in the comments below and we might just answer your questions in Tax Planning To and Through Early Retirement!

Sign up for updates about Tax Planning To and Through Early Retirement here: https://www.measuretwicemoney.com/book 

FI Tax Guy can be your financial planner! Find out more by visiting mullaneyfinancial.com

Follow my YouTube Channel at @SeanMullaneyVideos

This post is for entertainment and educational purposes only. It does not constitute accounting, financial, investment, legal, or tax advice. Please consult with your advisor(s) regarding your personal accounting, financial, investment, legal, and tax matters. Please also refer to the Disclaimer & Warning section found here.